(A Committee of Correspondence)

22 January 2009

Oil, Commodities, Instability?

Is the price of oil settling on a long term price of $40 a barrel? Some hard evidence is showing up. The Iranian government is setting its 2009-10 budgets on a price of $37.50. This week’s price started below $40 but March futures are in the $43/$44 range. The world recession is tracking to have an equal impact on the price of commodities.

Not being an economist, I would have assumed that consumption was in sharp decline and thus the supply and demand cycle kicked in. It appears this has been aided by the action of hedge funds as well. From Steve Austen’s blog: http://www.oil-price.net/#20080105#20080105

But when the banking industry collapsed, hedge funds had to raise cash by "deleveraging", liquidating their leveraged energy ETF positions sending the price of oil tumbling. Anecdotally shorting of banking ETFs was suspended by the US Securities Commission during that time but not shorting of energy prices, and the leverage mania soon found an escape route in utrashort oil ETFs, compounding the speed of this downward spiral. By December 2008 the oil price had collapsed 75% and frankly, who would complain about cheap gas these days?

As we enter 2009 the oil landscape has reversed dramatically from a year ago. The price of oil is lower than production costs and new exploration projects are being cancelled. China flush with cash is currently buying all the oil it can get its hands on to pump into its strategic reserves. Once arrogant OPEC countries are willing to sell oil at any price to fund government programs and prevent political instability.

Skipping the word arrogant, the last paragraph does hit on one very big point. With the price of oil lower than production costs, there is no economic support for expanding supplies in current fields or bringing new ones on line. It should not surprise that one of the few counters that a state directed/controlled oil or commodities supply has to counteract the fall of prices is to pump more oil or produce more commodity, trying to make up in volume that being lost in price. Globally, this, of course, further depresses prices. The added complexity is if the lower prices last long enough, potential production will fall as producing fields, mines, etc. begin to decline. Mr. Austen was discussing a potential 9% overall drop in production capability in as little as 12 months.

South American countries like Ecuador – Argentina – Brazil and African countries like Nigeria - Congo have dramatically increased their trade in commodities with China and other countries and were rewarded with historically high prices. Of course, they will find their income tied to the declining consumption rate of China and other consumers. The government agendas of many of these countries have been tied to the funding generated by the pre-recession price of oil and commodities. These cash flows are attractive for many reasons but perhaps the most telling geopolitical plank is this. Rather than more constrictive rules imposed by IMF loans or foreign aid, these cash flows are at the direction of the sitting government without behavioral controls.

“”Bolivian leaders said Venezuelan aid comes with fewer strings attached. "In the case of the United States, we're locked into specific areas -- aid for roads, aid for health, aid for electricity," Ãlvaro Garci­a Linera, the vice president, said in an interview in his office. The Venezuelan aid "allows us greater flexibility to choose projects with more productive impact, especially those ventures that include a state presence."”

What parts of the world would we see most impacted if the price of oil and other commodities stay depressed for two years? South America’s newer Socialist governments are heavily leveraged on this type of income for their internal programs. They have raised the expectations of the poorest of their population.Mexico appears to be trying not to become a narco-state, this before oil prices reduced income from PEMEX. And Africa, with no sarcasm intended, beggars the imagination to think about sections of that continent with another major stressor if, most certainly when, income from oil and commodities almost totally dry up from lack of demand. Could more states catastrophically fail and join Somalia, spurred on not only by political instability but also by a starvation of capital?

The West is faced with daunting internal challenges for our economies. In the US, we will be borrowing trillions to fix our own economy in the next few years. What will we have in the way of desire, interest, influence, resources and leverage if the trend is towards instability and chaos in these regions?

For me, the answer is clear. We will hopefully focus far less at throwing money at problems and demanding first place at the table, to tell nations what to do. We will stop using money and military aid in creating dependent states that always seem to end up with abusive governments. We can facilitate, support and lead (when it is helpful not because we are the only remaining superpower in the world). And we will let the natural leaders, the centers of gravity in these other hemispheres, begin to direct traffic. In the end, we may just see a world that stops looking to us for all the answers (and money) and begins to solve its own problems. But, geopolitically, it would appear that it is going to be a very ugly time for the next several years.

Comments

Oil, Commodities, Instability?

Is the price of oil settling on a long term price of $40 a barrel? Some hard evidence is showing up. The Iranian government is setting its 2009-10 budgets on a price of $37.50. This week’s price started below $40 but March futures are in the $43/$44 range. The world recession is tracking to have an equal impact on the price of commodities.

Not being an economist, I would have assumed that consumption was in sharp decline and thus the supply and demand cycle kicked in. It appears this has been aided by the action of hedge funds as well. From Steve Austen’s blog: http://www.oil-price.net/#20080105#20080105

But when the banking industry collapsed, hedge funds had to raise cash by "deleveraging", liquidating their leveraged energy ETF positions sending the price of oil tumbling. Anecdotally shorting of banking ETFs was suspended by the US Securities Commission during that time but not shorting of energy prices, and the leverage mania soon found an escape route in utrashort oil ETFs, compounding the speed of this downward spiral. By December 2008 the oil price had collapsed 75% and frankly, who would complain about cheap gas these days?